SDNY Decides Section 16 Case Regarding Matching of Two Classes of Common

By Cydney Posner

The SDNY has addressed an issue of first impression in a very recent (August 8) Section 16 case, Gibbons v. Malone (copy attached). The issue was whether different classes of common stock (voting and non-voting) can be matched for liability purposes. The court held that they could not.

In addition to voting rights, the two classes of common also differed with regard to stock dividend rights (Series A could receive a distribution of Series C but not vice versa), but otherwise had the same cash dividend and liquidation rights. The plaintiff alleged that defendant Malone made ten purchases of Series A and nine sales of Series C at higher prices, realizing a short-swing profit. The court disagreed and granted the defendant's motion to dismiss.

In the decision, the court characterized the plaintiff's matching theory of liability as "novel," and concluded instead that the plain text of the statute required that the purchase and sale be of the same equity security: "The drafters specifically chose to group ‘purchase and sale' and ‘sale and purchase' into single compounded units. This indicates that, to incur Section 16 liability, an insider's ‘purchase and sale' or ‘sale and purchase' must both be directed at the same prepositional object – the same equity security." The inclusion of the word "any" before equity security did not mean that liability would accrue from buying any security and selling any security, but rather that any of the various types of equity security within the statutory definition could provide a basis for liability. In addition, the securities were not derivatives or convertible into each other, so they were not functional equivalents.

The plaintiff also contended that the different classes were really just different "series" of the same class and therefore matchable. The court found instead that the two series were sufficiently different to be viewed as separate classes. Looking beneath the label of "series," the court focused on the differences in voting and dividend rights, the lack of convertibility, and the existence of a separate options market only for the Series A. Further, even though plaintiff alleged that the prices for each series were highly correlated, their prices did not rise or fall in unison and were not "fixed" to each other. These factors led the court to conclude that, notwithstanding their corporate title, the two series constituted two separate classes of common.

The court was likewise not swayed by plaintiff's policy argument that precluding matching in this case would encourage evasion of Section 16, but instead took into account prior Supreme Court rulings, which had recognized the "arbitrary nature" of Section 16 and concluded that satisfying the Congressional purposes of Section 16 would "not require resolving every ambiguity in favor of liability…"

As noted by Section 16.net, the "SEC staff has taken the position for over 20 years that two classes of common stock that differ only as to voting and dividend rights should be treated as separate classes of common stock, but the staff's position applies only for the purpose of determining whether a person owns more than ten percent of a registered class, making that person subject to Section 16. The staff has left open the question whether two classes of common stock may nevertheless be considered a single class for purposes of Section 16(b), such that a purchase of securities of one class could be matched with a sale of securities of the other class." Although it's not known whether the decision will be appealed, and this single case is not dispositive of the issue across all circuits, the court's decision here does provide some needed guidance.